Losses widened at Chelsea Stores, which owns the Early Learning Centre and Daisy & Tom children's goods businesses, as directors tried to update the operations to compete in a fast-changing retail market.

However, shareholders including Tim Waterstone, the book-trade entrepreneur, and the DC Thomson publishing group are in line for big gains if Chelsea Stores is sold to Mothercare, which yesterday said UK store sales fell in the latest period.

Accounts filed by Chelsea Stores Holdings at Companies House show that the group had a tough time in the 52 weeks ended May 6, 2006, during which directors pushed through a raft of changes to update the operations, while grappling with rising costs.

Underlying operating profits fell from £7.8m in the 13-month period ended May 7, 2005, to £2.7m in the period covered by the latest accounts.

Turnover fell from £205.7m to £186.1m.

After writing off £2m in the preceding year, when directors launched a programme to re-vitalise the operations, the company provided £4.9m against valuation of the Daisy & Tom children's store chain and £0.8m for ELC store closures.

Waterstone and backers bought ELC for £62m from 3i in April 2004. The venture capitalist backed a £20m buyout of ELC from Edinburgh-based John Menzies in 2001.

DC Thomson paid £8m for a 35% stake in Chelsea Stores, a company set up by Waterstone to merge ELC with his upmarket Daisy & Tom chain.

Chelsea Stores made a pre-tax loss of £9.8m in the latest financial year, compared with a loss of £1.4m in the preceding 13 months.

Comments in the directors' report in the accounts show the extent of the challenge they have been tackling.

"The financial performance in the year further emphasised the need to drive the strategic plan forward to differentiate the brand propositions in a competitive UK retail market, in which retailers are experiencing upward pressure in store operating costs, and seek out international growth opportunities."

The company has been investing in new products and packaging, refurbishing stores, improving its online sales capacity and opening 10 new international franchises. The group has around 215 outlets, including 74 overseas.

However, a spokesman for Chelsea Stores said it was happy with trading in the current year. In the 47 weeks of the year to date Early Learning Centre increased like-for-like sales 4.8%.

Shareholders including the US venture capitalist Rhone Capital remain in discussions about a lucrative disposal of the group to Mothercare. Last month the baby goods retailer confirmed it was in talks about a cash-and-shares deal valuing Chelsea Stores at £85m.

Bridgewell analyst Paul Deacon said such a move could deliver substantial synergies for Mothercare, which yesterday announced that like-for-like sales for UK stores fell 0.3% in the 11 weeks to March 31.

UK store like-for-like sales increased 0.8% for the year to March 31.